There are some that look at the European Sovereign Debt Crisis as a cautionary tale, but the reality is that the U.S. has a greater chance of entering a prolonged period that will be more Japanese-like than Greek.

To briefly review, as a result of a burst real estate bubble, Japan entered a deflationary trap characterized by high unemployment and slow growth in the early 1990’s which, except for brief periods, it has not been able to get out of.

Despite all of the government’s spending and the Fed’s balance sheet expansion, long term unemployment in the U.S. is still the highest it has been since the 1930’s. At the same time, measures of headline and core inflation have been decelerating rapidly (core inflation grew at an anemic 0.1% annualized pace in the 3 months to April).

The economy lost 8,000,000 jobs in the Great Recession and has created about 500,000 jobs in the past four months. Of those, around 80,000 are temporary Census workers, which means that only about 5.25% of the loss has been made up. And with GDP forecasted to slow in H2 2010 from Q4 2009 and Q1 2010’s rapid pace, we can’t expect to see the rate of job creation increase.

What’s really needed at this time in the U.S. is additional government spending but in the current political environment, it would be impossible for the administration to get Stimulus II passed by Congress. So, what can be done?

  1. The administration is going to have to work very hard at rearranging its spending in order to put every dollar it can to work creating jobs, primarily by finding ways to cut waste.
  2. Reinstate the $8000 housing tax credit.
  3. The Fed, rather than moving closer to an exit strategy, should re-start its program, to buy Treasuries, mortgage backed securities and agency debt

If you look at what’s happening with the European Sovereign Debt Crisis, the problems are strikingly reminiscent of Latin America in the 1980s. After heavy borrowing in the 1970’s drove up their debt-to-GDP ratios, they lost access to capital markets and the ability to roll over debt as it was coming due. For 10 years they were stuck with debt overhangs, just like the weak euro-zone countries, which made it virtually impossible to grow.

Greek Prime Minister George Papandreou’s comments this week outline the difficulties that Greece faces; While the government cuts fiscal spending, he said, it needs new private business to employ the dismissed workers so that they are productive, can pay taxes and do not need unemployment benefits. But if you look at what’s happening in Ireland, you’ll begin to understand just how difficult the situation is.

Ireland was one of the first nations to introduce tough fiscal austerity in this cycle. In spring 2009, the government slashed public-sector spending and raised taxes. Despite the cuts, the European Commission forecasts that Ireland will have one of the highest budget deficits in the world at 11.7% of gross domestic product in 2010. The problem is clear: when you cut spending you also lose tax revenues from people who earned incomes from that money. Further, the newly unemployed seek benefits, so Ireland’s spending cuts in one category are partly offset by more spending in another. Without growth, the budget deficit still looms large.

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